SAS, FAS and SOPsthrough contract issues, and possibly avoid costly mistakes. July 30, 2004 Wiley...

SAS, FAS and SOPsSAS, FAS and SOPsHow to Make Friends with YourHow to Make Friends with Your

CFO While NegotiatingCFO While NegotiatingSoftware & Tech ContractsSoftware & Tech Contracts

Gregory P. Cirillo

LSI “Telecommunications Deals for Carriers” San Francisco, California

July 30, 2004

July 30, 2004 Wiley Rein & Fielding LLP 2

OverviewOverview

• Most lawyers are not CPAs or MBAs– … but the contracts we negotiate are chock full of accounting and finance

implications – some are surprisingly subtle.

• Accounting– Revenue recognition– Accounting for the cost of software development

• Finance– Turning a receivable into a leveraged asset.


SAS 70 SAS 70 ––Special AuditSpecial Audit• Statement on Auditing Standards No. 70

– Issued by the American Institute of Certified Public Accountants (AICPA, an organization analogous to the ABA).

• Aimed at ensuring the quality of systems that act as a source of financial data.

– SAS 70 provides guidance to auditors on how to conduct an audit to enable an independent auditor to issue an opinion attesting to the quality of a service organization's financial controls.

– Applies to “service organizations” meaning ASPs, banks, brokerages, or similar firms that provide “outsourced” business functions to their customers.

– It is not mandatory, but many service organizations choose to get a SAS 70 audit to enhance their market position.


SAS 70SAS 70

• Deeper analysis:– Not all SAS 70 Audits are alike.

• Level I Audit – Results in an opinion that the service organization’s controls are consistent with its own description of those controls; and that those controls are are suitably designed to meet their intended control objective. No testing is done to back up this opinion.

• Level II Audit – All of the above, plus the controls have been tested and they provide sufficient effectiveness to provide reasonable assurance that the control objectives were achieved.


SAS 70SAS 70

• Deeper analysis:– The Sarbanes-Oxley Connection:

• SOX Section 404 requires management to verify the effectiveness of its internal controls, including documentation and evaluation of all controls that are significant to the financial reporting process. If the If the organization uses a service provider to process transactions, hoorganization uses a service provider to process transactions, host st data, or other significant services, management will look to thedata, or other significant services, management will look to the service service organization for information and support.organization for information and support.

• The service provider that has a SAS 70 audit on file will be saved a great deal of time and effort responding to individual customer needs.

• The SAS 70 audit is date sensitive, so it must be repeated annually.


SAS 70 in ContractsSAS 70 in Contracts• Customer concerns.

– If you are subject to SOX 404, then you may need a SAS 70 audit (or equivalent comfort) from all affected providers. There should be an internal policy on this at your company.

– If not subject to SOX 404, you may still want that SAS 70 audit.

• You may be going public.• You may get acquired by a public company.• SAS 70 audits can only help.

– Although, there is plenty of critique of SAS 70 by technical consultants.


SAS 70 in ContractsSAS 70 in Contracts• Service Provider Concerns.

– Do you take the plunge?• Do you provide functions for clients that have any impact on their

financial reporting?• If you do not have a current audit, you are at a disadvantage.• It is not an inexpensive audit, and it’s only good for a year.

– Do I get a Level I or Level II audit?• It is unclear whether SOX 404 calls for Level I or Level II.

– Do I use the customer’s auditors?• What if the customer does not like the auditors you use?

– Is an annual audit going to satisfy all (or enough) of my customers?

• Gap periods will create problems for some customers.• Quarterly, Level II audits are the best outcome, but very costly.


SAS 70 in ContractsSAS 70 in Contracts• Contracts Clauses:

• Requirement of SAS 70 audit for each year of the contract.– Of course you have to pass. Is it a breach to flunk the audit?– Is there a right to cure if the provider flunks?– Phase I or Phase II Audit?– Who bears the cost of the audit (and the remedial actions)?

• SAS 70 audit upon customer’s demand.– Consider tying it to an event – customer being subject to SOX 404.

• Piggy-back clause – Customer gets to see the audit if any other customer gets it.

– The free rider problem -- paying customer may object.– If you flunk the audit for one customer, is there any obligation to

advise other customers that you flunked?


Revenue RecognitionRevenue Recognitionin Software Salesin Software Sales

• AICPA Statement of Position 97-2

– SOP 97-2 provides detailed guidance on when and how a software vendor can recognize income on the sale of software.

– The structure of a software contract, and the way it is managed,can have a significant impact on the vendor’s financial statements.

– Knowing the vendor’s accounting concerns can help you sort through contract issues, and possibly avoid costly mistakes.


Revenue Recognition (SOP 97Revenue Recognition (SOP 97--2 & SFAC 5)2 & SFAC 5)

• Backbone of SOP 97-2:– If an agreement to deliver software or a software system does not

require significant production, modification or customization, then revenue should be recognized when:

• There is persuasive evidence of an agreement, and• Delivery has occurred, and• The seller’s fee is fixed or otherwise determinable, and• Collectibility of the fee is probable.

– A more general analysis of revenue recognition (and the basis for the above standards) is in FASB Statement of Financial Accounting Concepts No. 5 (SFAC 5).


Revenue Recognition (SOP 97Revenue Recognition (SOP 97--2)2)

• SOP 97-2 in Action:– The existence of an “agreement” will be based on the company’s

prior practices in contracting, as well as industry standards.– Delivery in the context of software mean acceptance.– The vendor’s fee is not “fixed” if it remains subject to discounts or

premiums, or portions of payment are suspended until certain conditions are met.


SOP 97SOP 97--2 in Action2 in Action• One Contract, Several Events

– Software Consulting, Development, Systems Integration and Support Agreement – Rough Overview:

• Consulting– Revenue recognized when a work plan or design spec is complete.

• Development– Revenue recognized when the software is delivered and accepted.

• Integration– Revenue recognized on a hardware component upon invoicing.– Revenue recognized on integration services upon completion.

• Support– Revenue recognized upon invoicing.


SOP 97SOP 97--2 in Action2 in Action• One Contract, Several Events

– If the fee is not segregated, the service provider will have to allocate the fee over the various elements based on a “fair value” analysis with objective basis. As a result, service providers should favor a clear allocation of the fee.

– If the service provider cannot make this allocation, it may be forced to defer all revenue recognition until all elements of the arrangement have been delivered or performed.


SOP 97SOP 97--2 in Action2 in Action• Discounts and other “side deals.”

– For the same reasons stated, if a vendor ties the sale of one software deal to a significant discount on future goods or services, SOP 97-2 may require the vendor to suspend a portion of the revenue from the first deal until it is determined whether the discount is subsequently taken.

– Income deferred will be based on a formula reflecting the relative value of the discount as a percentage of the original sale.


FASB 5 FASB 5 –– Big Sister to SOP 97Big Sister to SOP 97--22• Statement of Financial Accounting Standards No. 5.

– If SOP 97-2 = “Don’t count your chickens until they are hatched.”– Then FASB 5 = “If it’s an omelet, you cannot count it as a chicken.”

– FASB 5 requires a charge against income in the event that a future gain is placed in doubt due to a future contingency, if the amount of the potential loss is reasonably determinable. If it is not reasonably determinable recognition of the entire stream of income may end up being deferred until the contingency is resolved.

– SOP 97-2 states that “… obligations related to warranties for defectivesoftware, including warranties that are routine, short-term, and relatively minor, should be accounted for in conformity with FASB Statement No. 5…” meaning that the vendor must account for the sale of software with due consideration of its future warranty obligations, including “free upgrades and patches.”


SEC Staff Accounting Bulletin 101SEC Staff Accounting Bulletin 101• For public companies, there is one more hurdle.

– SEC Staff Accounting Bulletins 101, 101A, 101B and 104.• Issued by the Securities and Exchange Commission Division of

Corporation Finance and the Office of the Chief Accountant.• All deal with revenue recognition (not limited to software).• Apply to companies subject to SEC oversight.

– Those with publicly traded debt and equity.

– The principles are consistent with FASB/AICPA guidance on the same point.


Software Deals and Revenue RecognitionSoftware Deals and Revenue Recognition

• Separation of design, development, integration & support.– It’s not just to make the documentation redundant and annoying!– Separation of segments and the associated fees simplifies the accounting.– Milestones have an accounting purpose – they may trigger a revenue

recognition event.– Acceptance periods and acceptance procedures also serve an accounting

purpose. Open ended acceptance rituals can directly affect income.

• Discounts penalties, premiums and side-deals.– Other than “insignificant” discounts, any discount or side-deal will have an

effect on the revenue recognition – possibly deferring income until the customer either uses or loses the future right to discount.

– Discounts and other “kickers” need to have an expiration date in order to allow the vendor to capture any suspended income.

– Any provision that suspends or makes payment contingent can derail the income stream until the final tab is determinable.


Software Deals and Revenue RecognitionSoftware Deals and Revenue Recognition• Warranties.

– Warranties are often the most hard-fought provisions in a contract.– To the customer, the goals is reducing expenses for defective products.– To the vendor it is:

• A battle to minimize its future free performance obligations, AND• an effort to permit full revenue recognition as soon as possible.

– For a customized end-product (versus off-the-shelf) the accounting issues are more significant.

• Warranty claims can be significant, and difficult to determine.

• Limitations of Liability.– FASB 5 is not just about warranties; it’s about any contingent liability. By

placing a monetary limitation on liability, then the “worst case scenario” in a contract gone wrong is a capped amount (often relating to the amount paid).


Software Deals and Revenue RecognitionSoftware Deals and Revenue Recognition

• Bait & Switch – Use of financing intermediaries.• For cash flow reasons, some equipment/software vendors will assign your

payment obligation to a third party.– The third party pays the vendor an up front amount for the stream of

payments. No more revenue recognition problem!• In most cases, your contract will include a so-called “hell or high water” clause

which makes the customer’s payment obligation unconditional.– No abatements, offsets or withholding allowed, regardless of the vendor’s

performance.– Your recourse for a vendor default is to make a claim, or file a lawsuit against

the vendor while, at the same time, making your contract payments.• Problems with H or HW clauses:

– Vendor loses incentive to assist you.– Vendor’s bankruptcy guts your breach claim, but does not release you from

paying through the contract term.• What to look out for:

– Assignment clause – Do not let service get separated from payment!– If you are going to let the vendor do it, know your risks and try to get a piece of

the benefit.


FAS No. 86FAS No. 86• Statement of Financial Accounting Standards No. 86

– Issued by the Financial Accounting Standards Board to help software developing companies to account for the costs of developing software.

– Expense or Capitalize?• When a cost is “expensed” it is an immediate hit to earnings (offsets income).

This is favored accounting treatment to a profitable organization.• When a cost is “capitalized” it gets treated as an investment in a capital asset

which is later to be depreciated over time.– IPO-centric tech companies prefer capitalizing expenses because it improves

the income statement. Profit is boosted in the short term.– Established, profitable companies do not want to capitalize an expense.

• FAS 86 started with an SEC pronouncement. SEC tends to deal with companies that overstate earnings.

• FAS 86 was intended to make financial statements more consistent.


FAS No. 86FAS No. 86

• Statement of Financial Accounting Standards No. 86– Costs incurred in creating a computer software product shall be charged

to expense when incurred until technological feasibility as been established.

– A software product has established technological feasibility when:• A detail program design has been completed; or• A working model has been completed.

– Thereafter, the production costs are to be capitalized.• Once capitalized, the “asset” needs to be reduced to its market value each

year.• The asset is then depreciated over its economic life.


FAS No. 86FAS No. 86

• Application:– FAS 86 applies to the cost of developing computer software:

• When it is being developed for sale or lease.• When it is being developed for incorporation into a product to be sold or

leased.

– FAS 86 applies to software developed in-house for sale or lease, and software developed by a service provider for sale or least.

– FAS 86 does NOT apply to software developed under contract for aknown customer.


FAS No. 86FAS No. 86• FAS 86 and Development Contracts:

– Hypotheticals to which FAS 86 applies:• Hypo 1: Software company is developing a product in-house prior to having

any customers for it (off-the-shelf commercial product).• Hypo 2: Hardware/equipment company is developing a product in-house for

incorporation into a piece of equipment for sale.• Hypo 3: Hardware or software product company is contracting for development

of the product for subsequent sale.

– Contractual Relevance:• Hypo 1: For a major investment, it never hurts to know if your company is in

favor of capitalizing or expensing costs. Shock your CFO by asking!– If the vendor does not want to expense costs early, it may prefer to develop the

product without a customer under contract; or perhaps as a “beta” trial user instead of a customer.

– From the user perspective, you accept being a “beta” customer, but be mindful of the risks.


FAS No. 86FAS No. 86• FAS 86 and Development Contracts:

– Hypothetical #3: Developing Software of Sale

• If you are using a contractor to develop software for resale or incorporation into a product to be sold, keep FAS 86 in mind because it will apply to you.

– The contract should be clear on when the magic transition occurs (when you stop expensing and begin capitalizing).


BIG DISCLAIMERBIG DISCLAIMER• We’ve just scratched the surface.

–– Do not try this at home!Do not try this at home! There are many layers of accounting guidance.• Statements of Position (AICPA)• Guides (AICPA)• Technical Practice Aids (AICPA)• FASB Statements

– Statements of Financial Accounting Standards (FAS)– Statements of Financial Accounting Concepts (FAC)

• FASB Staff Positions (FSP)• FASB Interpretations• SEC Rules, Bulletins and Guidelines

– Hopefully, we take away a greater sensitivity to key accounting issues and how they affect many software and services contracts.


Web SourcesWeb Sources• www.fasb.org

– FAS 86– FASB 5– SFAC 5

• www.aicpa.org– SOP 81-1– SOP 94-6– SOP 98-1

• http://www.sec.gov/interps/account.shtml– SEC SAB 101, 101A, 101B and 104


Contact InfoContact InfoGreg Cirillo

Wiley Rein & Fielding LLP7925 Jones Branch Drive

McLean, VA [email protected]

www.wrf.com

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